erm surah yusuf

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Preace

Foreword

Acronyms

Table o Contents

Task Force on Islamic Finance and Global Financial Stability 11

Introduction: Financial Crisis and the Financial Reorm Agenda 13

A. Appreciating the Islamic Finance Model 16

I. Key Principles

Box 1: Basic Principles o Islamic Finance 16

Box 2: Participatory Mode in Fund Mobilisation 17

Box 3: Distinct Features o Islamic Financial Transactions:Perspective onmusharakah mutanaqisah (Diminishing Partnership) 21

Box 4: Non-Prot/Unilateral Contracts in Islamic Finance 23

Box 5: Islamic Micronance:Ar-Rahnu 24

B. The State o Islamic Financial Services Industry 26

I. Increasing Signicance o Islamic Finance in the Global Financial System 27

II. Perormance o Islamic Banks 34

III. Perormance o Islamic Indices 37

C. Challenges and Strategies or Strengthening Financial Stabilityin the Islamic Financial System 40

I. Strengthening Islamic Financial Inrastructure 41

II. Accelerating Eective Implementation 48

III. The Establishment o a Platorm or Constructive Dialogue:

Islamic Financial Stability Forum 51

Conclusion 53

Appendix I : Standards and Guidelines Issued by the IFSB 54

Appendix II : Comparative Table on Standards and Guidelines Issued by the

Islamic Financial Service Board and Basel Committee on

Banking Supervision 57

Appendix III : Comparative Table on Standards Issued by Islamic Financial Service

Board and International Association o Insurance Supervisors 61

Appendix IV : Al-Quran: Surah Yusu (Joseph) Verses 43 - 49 68

Reerences 69


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PREFACE

The Task Force on Islamic Finance and Global Financial Stability was ormed

on 29 October 2008 in response to the recommendations o the Forum o

the Global Financial Crisis and its Impact on the Islamic Financial Industry,

which was organised by the Islamic Development Bank (IDB) Group. The Task

Force headed by H.E. Dr. Zeti Akhtar Aziz, Governor o Bank Negara Malaysia

includes an international group o eminent scholars, practitioners and experts

in Islamic inance.

The irst meeting o the Task Force on 20 January 2009 led to the ormation o

three working groups to (1) examine the conceptual aspects o Islamic inance

and its role in enhancing inancial stability; (2) conduct stocktaking o the state

o the Islamic inancial services industry ollowing the global inancial crisis;

and (3) examine the inancial architecture o the Islamic inancial industry

amidst the more challenging post crisis environment.

The report o the three working groups were presented and discussed at the second

meeting o the Task Force held at the IDB headquarters on 28 March 2009 in

Jeddah. This document has drawn on the work o the three reports, incorporating the

discussions and comments by the members o the Task Force. This report concludes

with recommendations to strengthen urther the institutional arrangements in the

Islamic nancial system.

As authorities worldwide are working hard to reorm inancial systems and

policies, this will be a suitable time to give the Islamic inancial industry

the opportunity to participate in the process. The global inancial crisis has

demonstrated that we ace common challenges. In joining and sharing lessons

with international organisations, we can work towards avoiding such inancial

crises in the uture. We believe that there is much that Islamic inance can


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contribute to this process. From this perspective, the new inancial order

would be more inclusive and more global in nature, lending it more support

and sustainability. Collectively, we hope that we will be able to build a more

stable and more peaceul world or the uture generations.

I would like to thank H.E. Dr. Zeti Akhtar Aziz or her pioneering endeavours

in supporting Islamic inancial industry in general, and or guiding the work

o the Task Force in particular. I would also like to thank each and every

member o the Task Force, as well as all the supporting sta at IRTI and IFSB.

I pray that this eort will be a helpul step towards the good o mankind and,

subsequently, or the blessings rom the Almighty.

Dr. Ahmad Mohamed Ali

President o the IDB Group


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FOREWORD

As a orm o nancial intermediation, Islamic nance incorporates several elements

that guide the process o the mobilisation and allocation o unds to generate

productive economic activity and inclusive development. Fundamental to Islamic

nance is the requirement that nancial transactions must be supported by real

economic activity. In addition, Islamic nance promotes prot sharing and hence

risk sharing. These elements limit the extent o leverage and place emphasis on

transparency and disclosure in the documentation o contracts. Embraced in its

entirety, Islamic nance promises to enhance the discipline that contributes towards

ensuring growth and nancial stability.

The global nancial crisis o 2008-09, unprecedented in modern history, has brought

to the oreront wide ranging issues concerning the stability and soundness o

nancial systems. This has prompted an extensive global re-examination by the

international community on the need or regulatory reorm and the adequacy o

the existing international nancial architecture and the search or a more enduring

solution. This Task Force on Islamic Finance and Global Financial Stability was

ormed to examine the key elements in Islamic nance that contribute to its viability

and resilience and to review the advancement o the Islamic nancial services

industry in the ace o the challenges o the current global environment.

Amidst this more challenging environment presented by the recent international

nancial crisis, the global expansion o Islamic nance has continued and its

development has remained dynamic. Today, Islamic nance has become one o the

astest growing nancial segments in the international nancial system. Its phase

o development that began in earnest as domestic-centric or Muslim economies,

has rapidly transormed in this recent decade to become internationally recognised

and accepted as a competitive and robust orm o nancial intermediation by all

communities. As Islamic nance extends its reach to serve the global community

and becomes an integral part o the global nancial system, it will however be

increasingly tested by risks and developments in the international nancial system.

The Islamic nancial services industry is also entering into a undamentally dierent

environment that will be signicantly infuenced by the international regulatory reorm

that is being undertaken in the post crisis era.


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For the Islamic fnancial services industry to thrive in this new environment and to

transition to the next level o development and trend towards greater international

integration, its level o resilience needs to be strengthened urther. Eight important

building blocks have been identifed in this report to urther strengthen the

oundations o the Islamic fnancial system. This is not only to ensure sustainedorderly development and integration o the industry into the international fnancial

system, but also to enhance the capacity o the industry to address the increased

risks and vulnerabilities in the newly evolving international fnancial environment.

While the endeavour to strengthen the Islamic fnancial system and the international

Islamic fnancial architecture is important in this highly integrated international fnancial

system, equally important is to have in place a platorm or greater international

engagement on the developments and issues concerning maintaining fnancial

stability in the Islamic fnancial system. Thus, included in the recommendations bythe Task Force is the proposal to establish the Islamic Financial Stability Forum (IFSF)

to serve as a platorm or the deliberation o issues relevant or ensuring fnancial

stability in the Islamic fnancial system. Whilst it will represent an important platorm or

addressing such challenges conronting Islamic fnance, the establishment o the IFSF

would also allow or an interace process with the international fnancial community in

the conventional fnance given the common interest o global fnancial stability.

In the course o preparing this report, numerous meetings were organised, including

consultations and consensus-building dialogues, to obtain views rom an extensivespectrum o participants in the Islamic fnancial system. This was aimed at achieving

a common understanding on the important issues aecting fnancial stability in the

Islamic fnancial system. I would like to take this opportunity to thank members o

the Task Force or their unwavering commitment and contribution to achieving our

mandate. It is hoped that the report will provide useul insights on Islamic fnance and

the important ocus that needs to be given to fnancial stability in the rapidly changing

international fnancial environment. Equally important is the capacity to contribute

to global fnancial stability. The priorities identifed in this report are also aimed at

strengthening urther the oundations that will ensure the sustainability and capacity oIslamic fnance to contribute towards global growth and a greater shared prosperity.

Dr. Zeti Akhtar Aziz

Chairperson, Task Force on

Islamic Finance and Global Financial Stability


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ACRONYMS

AAOIFI Accounting and Auditing Organization or Islamic

Financial Institutions

CDO Collateralised debt obligation

CIBAFI (General) Council or Islamic Banks and Financial

Institutions

CIS Collective investment scheme

IAH Investment account holders

IDB Islamic Development Bank

IFSB Islamic Financial Services Board

IFSI Islamic nancial services industry

IIFM International Islamic Financial Market

IIFS Institutions oering Islamic nancial services

IMF International Monetary Fund

IRTI Islamic Research and Training Institute

LOLR Lender o last resort

PSIA Prot sharing investment accounts

UPSIA Unrestricted prot sharing and loss bearing

investment accounts


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11Islamic Finance and Global Financial Stability

Task Force on Islamic Finance and

Global Financial Stability

I. Introduction

The Task Force on Islamic Finance and Global Financial Stability

(Task Force) was initiated by the Islamic Development Bank (IDB) on

29 October 2008 in response to the recommendations o the Forum

o the Global Financial Crisis and its Impact on the Islamic Financial

Industry, organised by the IDB Group.

II. Key mandates

The Task Force was entrusted with three mandates as ollows:

i. To analyse the role and relevance o Islamic nance in promoting

global nancial stability;

ii. To take stock o the progress o the Islamic nancial services

industry in the ace o the challenges o the current global nancial

environment; and

iii. To examine important strategies and key building blocks towards

urther strengthening the resilience o Islamic nance and advancing

global engagements towards promoting nancial stability in theIslamic nancial system as part o the current reorm process o the

international nancial system.


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III. Members

The Task Force is headed by H.E. Dr. Zeti Akhtar Aziz, Governor o

Bank Negara Malaysia and includes an international group o eminent

scholars, practitioners and experts in Islamic nance. The members o

the Task Force are as ollows:

1. H. E. Tan Sri Dr. Zeti Akhtar Aziz, Governor,

Bank Negara Malaysia, Chairperson

2. Shaikh Saleh Kamel, Chairman, General Council o Islamic

Banks & Financial Institutions

3. Proessor Riaat Ahmed Abdel Karim, Secretary-General, Islamic

Financial Services Board4. Shaikh Youse Talal DeLorenzo, Chie Shariah Ocer and Board

Member, Shariah Capital, Inc.

5. Mr. Michael McMillen, Partner, Fulbright & Jaworski LLP,

New York

6. Mr. Sameer Abdi, Lead Partner - Islamic Financial Services

Advisory Services, Ernst & Young Bahrain

7. Dr. Mohd Daud Bakar, Chairman, Shariah Advisory Council,

Bank Negara Malaysia

8. Dato Khawaja Mohammad Salman Younis, ormer Managing

Director, Kuwait Finance House (Malaysia) Berhad

9. Pro. Dr. Volker Nienhaus, President, University o Marburg,

Germany

10. Dr. Abbas Mirakhor, ormer Executive Director, International

Monetary Fund

11. Dr. Ahmed Ali Abdallah, Advisor to Governor and Secretary

General, Shariah Supervisory Board, Central Bank o Sudan

12. Dr. Sami Ibrahim Al-Suwailem, Deputy Director, IRTI, Islamic

Development Bank Group


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Introduction:

Financial Crisis and the Financial Reorm Agenda

1. The global nancial crisis o 2008-09 has brought to the oreront

issues concerning the stability and resilience o nancial systems.

At the heart o the crisis is the near-breakdown o the unctioning

o the nancial intermediation process, amid a generalised loss o

condence in the nancial system.

2. Many actors have been cited as the cause o the crisis. They

include a combination o misalignments in the incentive structure

and unbridled nancial innovation which led to indiscriminate

lending and excessive risk-taking. Other contributory actorsinclude the erosion o sound prudential practices, with banks

compromising on underwriting and risk management standards in

pursuit o short-term gains and market share. While the banking

institutions had employed increasingly sophisticated nancial

engineering techniques to repackage mortgages into complex

structured securities, such nancial innovation was not supported

by commensurate enhancements to their governance processes

and risk management inrastructure and practices.

3. In the wake o the crisis, the global nancial community has

intensied eorts to reorm the international nancial architecture to

ensure its stability and resilience in a more challenging environment.

The challenge beore us is to not only undertake the necessary

regulatory reorm that will minimise potential risks, but to also build

a new nancial architecture that will promote greater eciency in

the nancial intermediation process, including across borders.


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4. In the search or a new nancial architecture, there is a general

consensus on the need to return banking to its basic unction - to

provide nancial services that add value to the real economy. This

in act represents the very essence o Islamic nance. These are

the very elements ound in the Shariah principles that orm theoundation o Islamic nance. It is these inherent elements that

contribute towards the overall stability and resilience o the Islamic

nancial system. This oundation is urther reinorced by the values

that are extolled in Islamic nance that are similar to those ound in

ethical nance and socially responsible investment. The key strength

o the Shariah injunctions is its emphasis on a strong linkage to

productive economic activity, its inbuilt checks and balances and

its high level o transparency and disclosure. The Islamic nancial

services industry has thus been in a relatively stronger position toweather the global nancial crisis, demonstrating its robustness as

a stable orm o nancial intermediation. The inherent eatures o

Islamic nance have the potential to serve as a basis to address

several o the issues and challenges that have suraced in the

conventional nancial system during the current crisis. As the role

and relevance o Islamic nance in the global nancial system gains

signicance, it has potential to contribute to greater global nancial

stability and towards strengthening global growth.


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A: Appreciating the Islamic Finance Model

I. Key Principles

5. Islamic nance derives its key strength rom its inherent underlyingprinciples. Islamic nancial transactions must be accompanied

by an underlying productive economic activity that will generate

legitimate income and wealth, thereby establishing a close link

between the nancial transactions and productive fows. This

reduces the Islamic nancial system rom over exposure to risks

associated with excessive leverage and imprudent risk taking.

Thus, in the Islamic nance business model, nancing or equity

participation can only be extended to activities in the real sector

that have economic values. As a result, Islamic nancial assets are

expected to grow in tandem with the growth o underlying economic

activities (see Table 1 and Box 1).

Overarching Principles Towards achieving the objectives of Shariah (Maqasidal-Shariah)

High ethical values - justice, fairness, trust, honesty and integrity

Protection of religion, life, lineage, intellect and wealth

More equitable distribution of wealth

Materiality and Validity of Transactions

Economically productive underlying activitiesAvoidance of interest-based transactions No involvement in illegal and unethical

activities

Genuine trade and business transactionsAvoidance of speculative transactions

Embedded Governance

Mutuality of Risk Sharing Entitlement of prot contingent upon risk

taking

Honouring both substance and form ofcontract

Disclosure & Transparency

Table 1: Essential Features of Islamic Finance


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6. Islamic nance promotes transactions that are based on prot and

risk sharing. It encourages participatory nance or active participationin the business, throughmudarabah (partnership o work and capital)

andmusharakah (joint venture) contracts (see Box 2 and Table 2). This

approach promotes participation in the risk-reward and nancial results

or outcome o such businesses. This risk sharing requires the IIFS to

undertake the appropriate due diligence on the viability o business

proposals. Oversight and review by the relevant parties such as

Shariah boards or Shariah compliant review process provide additional

saeguards against irresponsible practices. In contrast, conventional

nancial instruments generally separate such risks rom the underlyingassets. As a result, risk management and wealth creation may, at times,

move in divergent directions, with adverse consequences or eective

risk management. Conventional nancial instruments also allow or

the commoditisation o risks. This has led to its prolieration through

multiple layers o leveraging and disproportionate distribution, which, in

turn, could result in higher systemic risks, thus, increasing the potential

or instability in the nancial system.

Box 1: Basic Principles o Islamic Finance

Prohibitionofinterest(riba). Prohibition o riba a term literally an excess and

interpreted as any unjustiable increase o capital whether in loans or sales.

Moneyaspotentialcapital.Moneyisnotacommodity,butamediumof

exchange, a store value and a unit o measurement. Money represents purchasing

power and cannot be utilised to increase the purchasing power without any

productive activity. Islamic nance advocates the creation o wealth through trade

and commerce.

Risksharing.Becauseinterestisprohibited,suppliersoffundsbecomeinvestors,

rather than creditors.

Prohibitionofspeculativebehaviour.Islamicnancediscourageshoardingand

prohibits transactions eaturing extreme uncertainties (gharar), and gambling

(maysir).

Sanctityofcontracts.Islamicnanceupholdscontractualobligationsandthe

disclosure o inormation as a sacred duty. This eature is intended to reduce therisk o asymmetric inormation and moral hazard.

Shariahapprovedactivities.Onlythosebusinessactivitiesthatdonotviolate

the rules o the Shariah qualiy or investment. For example, any investment in a

business dealing with alcohol or gambling is prohibited.

Socialjustice.Anytransactionleadingtoinjusticeandexploitationisprohibited.

Source: Adapted from Askari, et. al (2010)


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Unrestricted InvestmentAccounts

Mudharabah (profit sharing and loss bearing)

Table 2: Islamic Banking Balance Sheet: Distinct Contractual Relationship

Assets Liabilities

InventoryReal estates/Automobiles

Asset-backed TransactionsMurabahah (cost plus) / Ijarah

(leasing) /Istisna(manufacture) / Salam

(forward delivery)

Current/ Demand DepositsWadiah (Safe custody) / Qard(Loan)

Profit Sharing TransactionsMudharabah (profit sharing & lossbearing) /Musharakah (profit & loss

sharing)

Fee Based Servicese.g. Ujr(fee) Equity

Distinctcharacteristic-

ownership of assets Akin to demand

deposits but exhibitdifferently as it

prohibits gifts upfront/predetermined return

Akin to fixeddeposits but uses

profit sharing basiswhere return basedon performance of

assets

Profit Equalisation Reserves Distinct

characteristic as

prudential tool

Akin to loans butlegal position of

lender & borrower isreplaced by different

contractualrelationship

Investor-entrepreneurrelationship

Islamic Rate of Return Management (Asset Driven)

Return on Assets InvestmentReturns

Cost of FundsReturn on Lending

Conventional Asset & Liability Management (Liability Driven)

Unrestricted Investment

Accounts

Mudharabah (profit sharing and

loss bearing)

Restricted InvestmentAccounts

Mudharabah (profit sharing andloss bearing)

Box 2:Participating Mode in Fund Mobilisation

FinancialintermediationthroughIIFSinvolvesmobilisingfundsfromsaversor

investors with excess liquidity, using a combination o non-return-paying currentor demand accounts and prot sharing investment accounts (PSIA), and providing

these unds to rms or individuals or nancing assets or business activities. The

banker-customer relationship is not the conventional debtor-creditor relationship

but is based on dierent contracts that are entered into by the IIFS and the

customer.

AtypicalIslamicbankingbalancesheetisasfollows:

Liability Side: The liability structure o Islamic banks (i.e. unding structure) is

characterised by two distinct categories o unds:

o Non-return-paying demand/current accounts or which the principal is

guaranteed; and

o PSIA which reer to deposit products structured based on mudharabah (prot

sharing-loss bearing contract) where customers and Islamic banks agree to

share prots generated rom the assets unded by PSIA based on a mutually

agreed prot sharing ratio, while the loss shall be borne by the customers.


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Mobilisingfundsonaprotsharingbasismeansthat,inprinciple,thevalueof

liabilities adjust accordingly in response to any change in the price o assets. Even

i the price o the nanced assets remains unchanged, the expected returns or the

partners may all (or example, because o weak demand), which will subsequently

reduce the prot to be shared.

Thismodusoperandiservesasamajorconstraintonleverageandtheresultant

credit creation, and ensures a better alignment o the values o assets and liabilities.

The use o prot sharing modes to mobilise unds may imply that Islamic banks

ollow a model that is closer to that o mutual unds, which in principle, are less

vulnerable to runs and panics than the conventional banking model1.

Asset Side: On the asset side, Islamic banks enter into dierent nancing modes

which have a distinct intrinsic characteristic dictated by its underlying Shariah

principles.

o The wide range o nancing modes based on trade and commerce oered by

Islamic banks, such asmurabahah (cost-plus credit sale nancing),istisna

(manuacturing or construction nancing contract),salam (orward sale o

ungible goods or immediate payment),ijarah (leasing), etc. indicates that the

IFSI has a sucient range o products that can be used in meeting the needs

o its customers; and

o An Islamic bank may enter into joint venture as a means o nancing where

the Islamic bank acts as joint partner in a specic economic activity based ona pre-specied prot-and-loss sharing arrangement.

Thisformofintermediationisnotmerelythecollectionofaspreadbetweenthe

cost o unds mobilised and the return on unds advanced in the context o the

conventional debtor-creditor relationships but a more active economic role involving

either the provision o assets or services or entering into partnerships.

1 Khan and Mirakhor, 1987; Cowen and Kroszner, 1990; Jacklin, 1993


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7. The key thrust o Islamic nancial transactions is to have high

degree o transparency and disclosure in preserving the rights and

responsibilities o the parties to a contract. Islamic nance requires

the Islamic nancial institutions to undertake the appropriate due

diligence on the viability o business proposals and to meet therequirement or transparency and disclosure. Market conduct

disclosure and customer relationship management orm the core o

these principles. Addressing the inormation asymmetry between

Islamic banking institutions and the depositors/investors is o vital

importance. Under themudarabah principles, there is a need or

disclosure by Islamic nancial institutions to investors on how the

unds are being managed so as to provide the assurance that the

underlying business operations, the risk prole and the risk control

mechanisms are in place. Disclosure o the true and air value othe Islamic banking operations in the nancial statements is also

essential or depositors to undertake an inormed assessment

o the banks perormance. In the case o equity and investment

instruments, proper screening processes and disclosures are

imperative to increase the level o assurances that the investments

are invested in a Shariah compliant manner. The unds o the

Islamic investment product and those o the nancial institution in

which Shariah injunctions are not observed must be completely

segregated. This calls or the maintenance o separate accountsand disclosures, evidencing the complete segregation o unds.

Non-commingling o unds is essential and should be enshrined

and expressly stated in the statutes or the prospectus. The role

o the Shariah board in ensuring that all aspects o the business

operations o Islamic nancial institutions are in accordance with

the Shariah principles, adds another level o oversight which

inherently saeguards against irresponsible practices. These in-

built dimensions o governance and risk management contribute

to saeguarding Islamic nance rom the potential risks o nancialstress arising rom excessive leverage or speculative activities.


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8. These distinct eatures o Islamic nance represent the core

principles in determining whether a particular transaction or

institution all within the parameters o Shariah. When embraced

in its entirety, these essential Shariah eatures reduce the risk o

nancial instability. These principles are also integral to the orderlydevelopment o innovative Islamic nancial products and services.

Financial innovation in Islamic nance must be within these Shariah

parameters and tested against the Maqasid al-Shariah (objectives

o the Shariah), where the primary objective is the realisation

o benets to the people. This demands the internalisation and

preservation o Shariah principles in Islamic nancial transactions,

both in orm and substance in order to ensure that the religious

and ethical principles are not compromised. This is illustrated in

the example omusharakah mutanaqisah, an equity-based contractwhich has been widely accepted in many jurisdictions (see Box 3).

These inherent eatures o Islamic nance signicantly contribute

towards the nancial stability o the Islamic nancial system.


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Box 3: Distinct Features o Islamic Financial Transactions: Perspective

onMusharakah Mutanaqisah (Diminishing partnership)

Musharakah mutanaqisah can be applied in home nancing products. Based

on the joint-ownership concept, the banking institution and the customer

contribute their respective shares o the capital required to acquire the property

according to a mutually-agreed, pre-determined ratio at the beginning o the

contract. The banking institution leases the property to the customer who

undertakes to incrementally acquire the ull ownership o the property rom the

banking institution over an agreed period. Once the customer has ully acquired

the banking institutions share o the property, the partnership comes to an

end with the customer becoming the sole owner o the property. This contract

incorporates elements o both sale and lease (ijarah) contracts, which are integral

in ensuring that no element oriba (interest) is involved in themusharakah

mutanaqisah transaction.

TheapplicationofShariahprinciplesinmusharakah mutanaqisah contracts

creates distinct relationships, rights and obligations o the parties to the

contracts. As a result, banking institutions are exposed to both market risk

associated with the joint ownership o the underlying asset, as well as credit risk

associated with the obligation on the part o the customer to acquire, and on the

banking institution to sell its share o ownership in the asset. This distinct risk

exposure requires the banking institution to adopt more robust methodologies

supported by reliable and timely data and systems that are able to detect and

provide best estimates o potential losses arising rom adverse developments

in the credit prole o the customer. The risk management processes and

inrastructure o a banking institution oering such a product also need to be

dynamic in identiying, measuring, controlling and managing all the relevant

risks associated withmusharakah mutanaqisah transactions. Chart 1 shows the

key risk exposures and risk management practices at the dierent stages o a

transaction inmusharakah mutanaqisah, as well as additional risk mitigants that

can be introduced.


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9. The essential eatures o Islamic nance, notably its value

proposition o the sharing o risks and prots is reinorced by an

ethical approach to nancial transactions. Thus, this also involves

greater attention to non-prot transactions and the segments o

society with scarce capital, as well as attention to responsible

and ethical nancing. In this regard, the Islamic nancial services

industry is also attractive and viable or the less privileged

segments o society that generally do not have recourse or unds

except rom the inormal or shadow nancial sector. In the process,

the economic empowerment o the less ortunate would elevate

their status rom the non-bankable to the bankable segment,

thereby beneting the borrowers, the nancial system, and the

community at large, as well as increasing nancial inclusion (see

Box 4 and 5). The promotion o a more inclusive nancial system

T0: Acquisition ofProperty by the

Bank and Customer

Risk Management

Provide appropriatemechanism tocompensate the banksloss of future incomearising from earlysettlement.

T0 TM: Lease Rental &

Transfer of BanksOwnership

Tn: Customer Default

Risk Management

1. Incorporation of

purchase undertaking

(wad) as risk mitigant

(exit strategy) in the event

of default.

2. Use of security instruments (charge

on the underlying property) against the

non payment of rental.

Risk Management

Risk Management

Pre-agreed rental pricebased on nancialmarket indicators.

TM: Full Transferof BankingInstitutionsOwnership toCustomer

RATE OFRETURN RISK

Potential loss infuture incomearisingfrom earlysettlement

LEGAL RISK

Enforceability of

contract and

recognition of

benecial ownership

under the law

CREDIT RISK

Non-payment ofrental by thecustomer

MARKET RISK

Arising from theuctuation of marketprice (in the case oftransactions withoutwad)

Chart 1: Management of Key Risks inMusharakah Mutanaqisah Contracts

2. Proper assessment of customer

credit prole and valuation of the

property.

1. Ensure comprehensive

agreement to cover the rights and

obligations under joint ownership.


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Box 4: Non-Proft/Unilateral Contracts in Islamic Finance

Whilethenon-protdomaininIslamicnancehasbeeninoperationformany

centuries, it is less well known. This domain comprises institutions such aszakat,

sadaqah,awqafand similar philanthropic and social responsibilities, which are

considered just as essential as the or prot domain within Islamic nance. They

alsoperformbenecialeconomicsupportinservingthesafetynetarrangement.

Zakatmaybecomparedtoatypeofwealthtax,beinganobligationrelated

to dened types o assets rom which a part is to be paid by the owner o the

assets when the assets reach a certain amount (nisab). For example,zakat

on savings requires, inter alia, a holder o idle unds to contribute at a rate o

2.5% per annum to the eligible beneciaries. It becomes payable i the holders

monetary unds have been idle or one year. This negates the incentive or

hoarding, which the Holy Quran takes a strong position against.

Awqafrepresents the creation o an endowment whereby an asset or pool oassets is dedicated in perpetuity, primarily or charitable purposes. Historically,

awqafhas proven to be a useul institution in mobilising idle assets or

addressing poverty, as the beneciaries oawqafcan enjoy the benets o

education, healthcare, basic inrastructure and entrepreneurial assistance.

Theeconomicempowermentofthelessfortunate,ifcarriedoutinasystematic

and structured manner, may elevate them rom the non-bankable to the

bankable segment, thereby beneting the individuals themselves, the nancial

system, and the community at large, as well as increasing nancial inclusion.

would in turn improve the nancial intermediation process and

enhance the overall ecacy o nancial policies. Finally, through

increased nancial fows across borders, Islamic nance can

also contribute to closer economic and nancial linkages across

the world by promoting mutually reinorcing growth in the worldeconomy.


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Box 5: Islamic Microfnance:Ar-Rahnu

TheAr-Rahnu (Islamic pawn broking) scheme can demonstrate its role as a

viable microcredit product o the nancial institutions in meeting the dierent

customer requirements. Firstly, it represents a credit channel to those who want

to use theAr-Rahnu scheme to obtain nancial resources to meet their daily

nancial requirements; and secondly, it can be a credit channel to those who

require temporary working capital, particularly or small businesses.

The objective oAr-Rahnu is to create an alternative nancing channel to the

conventional pawn broking, that is not only more transparent but that also

complies with Shariah principles.Ar-Rahnu is a orm o microcredit product

where the borrower places valuable assets, such as gold, jewelry, as collateral

or the nancing. In the conventional pawn-broking, interest is charged on theloan and the collateral will be used in the event o deault. In theAr-Rahnu

scheme, there is no element o interest and the nancing is usually given on

qard (loan). However, the borrower must pledge a valuable asset as collateral on

the nancing. The maximum amount o the nancing as practised in Malaysia,

Brunei and Indonesia is around 60 to 75 per cent o the value o the pledged

item. The nancial institution (the lender) would accept the pledge on wadiah

(sae-custody) concept where the nancial institution promises to sae-keep

the pledged asset until the nancing is settled. The nancial institution would

impose a charge on the borrower or services rendered which may includetakaul coverage and security or the pledged asset. In the event o a deault,

the pledged item will be sold to a third party. The proceeds will be used to settle

the outstanding balance while any excess will be returned to the borrower,

unlike conventional pawn broking where the excess will not be returned to the

borrower.


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10. In summary, the eatures and value proposition inherent in the

Islamic nancial model can have the potential to contribute to

global nancial and economic stability through the ollowing

channels:

a. Finance can only be extended to projects, trade, economicand commercial transactions. Financial assets can thereore

grow in proportion to the growth in real economic activities and

minimise the possibility o excessive leverage.

b. Dont sell what you dont have is one o the undamental

principles o Shariah, which restricts the possibility o excessive

speculation.

c. Investments in public and private equities have to pass a set o

screening processes where social and ethical responsibilities

are an integral part o investment decisions.

d. Preserving genuine liquidity (as opposed to synthetic liquidity)

urther adds to the stability o the IIFS.

e. Managing procyclicality (such as dynamic provisioning) is

strongly encouraged where the concept has been narrated in

the Holy Quran2.

2 Surah Yusu - verses 43 to 49. Reer to Appendix IV or details


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B. The State o Islamic Financial Services Industry

11. The crisis had initially emanated rom the sub-prime market in an

advanced economy largely due to excessive credit activity in the

sub-prime mortgage sector. This was primarily acilitated through

nancial derivatives such as Collateralised Mortgage Obligations

(CMO), Collateralised Debt Obligations (CDO) and Credit Deault

Swaps (CDS). With integrated nancial markets and cross border

capital fows, the crisis spread to all regions o the globe resulting

in a sharp decline in investor condence, which consequently saw

the evaporation o liquidity in the global nancial system.

12. Islamic nancial institutions, which are subject to Shariahregulations, are orbidden rom investing in such derivative

instruments and thereore did not have exposure to such

derivatives. Also the holding o shares or the investment in

conventional nancial institutions which are involved in usury

orriba are not permitted. The combination o these actors

minimised the impact o the nancial crisis on Islamic nancial

institutions. However, the subsequent tightening o liquidity

and credit in the global nancial markets did adversely impact

all nancial institutions in general, including Islamic nancialinstitutions. As the nancial crisis become prolonged, the global

recession, the collapse in commodity and oil prices, and the sharp

erosion o asset values that ollowed, aected the perormance o

the Islamic nancial institutions.


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14. While the Islamic nancial services industry currently represents

approximately only 1% o global assets, it has been growing

by more than 20% annually since 2000. As at the end o 2007,

the combined revenue o international Islamic nancial services

is estimated to amount to USD53 billion, while Islamic protstotalled USD15 billion and is expected to more than double to

USD32 billion over the next 5 years. It is estimated that by 2012,

Islamic assets will reach about USD1,600 billion, with revenues o

USD120 billion.

15. Several key developments highlight the increasing signicance o

Islamic nance in the global nancial system:

a.The expanding asset base

. The industry hasrecorded strong growth with total Islamic banking assets o

USD660 billion at the end o 20073. In terms o geographical

distribution, the Middle East is now the largest Islamic nance

market, accounting or about 80% o global Islamic nance

assets. Chart 2 illustrates the regional distribution o

Islamic assets, revenues and prots and the relative regional

Muslim population4.

3 Oliver Wyman, 20094 Oliver Wyman, 2009


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Subcontinent Southeast Asia North Africa Turkey Iran GCC Levant RoW

0%

10%

20%

30%

40%

50%

60%

70%

90%

100%

Muslim population Islamic assets Islamic revenues Profit pools

80%

Regional breakdown as follows:Levant : Israel, Jordan, Lebanon, Palestine, Syria

GCC: Qatar, Bahrain, Kuwait, UAE, Saudi Arabia, Oman

North Africa: Algeria, Egypt, Libya, Mauritania, Morocco Tunisia, Sudan

Southeast Asia: Cambodia, Laos, Thailand, Vietnam, Philippines, Brunei, East Timor, Indonesia, Malaysia, SingaporeSubcontinent: India, Pakistan, Bangladesh, Bhutan, Nepal

Source:The Next Chapter in Islamic Finance Higher Rewards But Higher Risks (Oliver Wyman)

Chart 2: Muslim population, Islamic assets, revenues and profit

pool breakdown by region, 2007

A more recent survey encompassing the top 500 IIFS showed

that assets held by ully Shariah-compliant banks including

Islamic banking windows o conventional banks rose by 28.6%

to USD822 billion, rom USD639 billion in 20085. During this

period, the worlds top 1,000 conventional banks achieved anannual asset growth o just 6.8% as o July 2009 to amount to

USD96,395 billion.

b. Strong perormance. The strong perormance o Islamic

nancial institutions amid the crisis has urther supported its

growing signicance. Table 4 shows the comparison in terms

o aggregate size and perormance o Islamic banks and

conventional banks in the Gul region (Saudi Arabia, Kuwait,

Qatar, United Arab Emirates and Bahrain).

5 The Banker, Nov 2009


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c. Growing signifcance across regions, beyond predominantly

Muslim markets and jurisdictions. From being concentrated

in Muslim populated regions, Islamic nance has drawn

signicant participation by non-Muslims. Exceptional growthin Islamic nance has been registered not only in the Muslim

world, where its growth is premised on religious considerations,

but now spans across the western world and the Asia Pacic

region where the growth is driven by commercial and business

considerations. Although the Middle East and Asia remain by ar

the largest Islamic nancial markets in the world, other regions

and countries are also pursuing Islamic nance as a new asset

class. Its potential or growth and development in the uture

has triggered strong interest rom beyond Islamic incumbents.Chart 3 includes non-Muslim countries such as Australia, China,

France, Germany, Hong Kong, Italy, Japan, Korea, Luxembourg,

Singapore and United Kingdom, in which there are some

initiatives in introducing Islamic nance in their nancial systems.

China has issued its rst licence or Islamic banking, while ve

Islamic banks have been established in the United Kingdom

as at end 2009. Countries such as France, Korea and Japan

have also initiated changes to their legal and tax structure to

acilitate the introduction o Islamic nancial products into theirmarkets. Other countries including Hong Kong and Australia

have indicated their intention to advance this orward. This trend

is expected to contribute towards greater cross-border fows in

terms o increased trade and investment transactions, thereby

strengthening economic linkages.

Conventional Banks Islamic Banks

Assets (USD billions) 1,135,669 232,189

Prots (USD billions) 22,008 7,666

Asset growth 2007-08 16.3% 38.2%

Prot growth 2007-08 6.1% 20.1%

Prots/Assets 1.9% 3.3%

Source: El-Jarhi, 2009. Islamic windows in conventional banks are not included in Islamic banks.

Table 4: Islamic and Conventional Banks in the Gul Region, 2008


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Chart 3: Emerging interest in Islamic Finance

d. Rapid expansion of the sukuk market. With regard to Islamic

securities or sukuk, Thomson Reuters reported that the sukuk

market grew rom USD6 billon to USD24 billion between 2004

and 2007. However, in 2008, the sukuk market registered

a decline o about 30% due to the uncertainty in the global

capital markets6. Nevertheless, as the overall market conditions

improved, the sukuk market rebounded in the second hal o

2009 (see table 5). The huge potential in the Sukuk market is

evident rom the active participation o global players including

international investment banks, Islamic banks and securities

frms that have participated in the issuance o sukuk.

6 Tayyebi, 2009

Germany

Saxony-Anhalt stateissued governmentsukuk

First Islamic bank tooperate in 2010

Pakistan

Hong Kong

Aims to become Islamicfinance gateway to China

Plans to issue sovereignsukuk

Hang Seng Islamic ChinaIndex Fund in 2007

United Kingdom Government sets an objective to

entrench London as a globalgateway for Islamic finance

5 FSA-approved Islamic banks

Plans to issue sovereign sukuk,amend tax law on Islamic finance

UAE

Japan Law passedallowing banks toconduct Islamic

finance

France Passed

rules/regulations tosupport Islamic financeactivities

In process of licensingIslamic banks

Made fiscal & legaladjustment for IFtransaction i.e. taxationguidelines on sukuk &murabaha Singapore

Established first Islamic bank

Introduced tax neutrality for Islamicfinance

Launched Islamic ETF

South Korea

Parliament expected to pass thelaw related to offering of tax

waiver on foreign investors interest

income from sukuk issued

Qatar

SudanKuwait

SaudiArabia

Bahrain

Jordan

-

Muslim-majority countries offering Islamic finance (IF)Non-Muslim countries starting to offer Islamic finance

Indonesia

Brunei

Malaysia


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e. Growth potential o takaul in new and existing markets.

Takaul premium contributions have grown rom USD1.4 billion

in 2004 to over USD3.4 billion in 2007. The largest global

markets include Saudi Arabia and Malaysia. Saudi Arabia

remains the largest takaul market in the GCC with contributions

o USD1.7 billion in 2007. Malaysia remains the largest takaul

market in Asia with contributions o USD0.8 billion in 2007.

The other markets or takaul are Bahrain, Sudan, Kuwait and

Indonesia. Globally, takaul continues to record rapid growth in

new and existing markets7.

. Strong upside potential o Islamic und management

industry. In terms o Islamic unds, Shariah-compliant

investible assets in 2008 in the GCC and Asia reached

USD736 billion compared to USD267 billion in 20078

. Thisrepresents a potential annual revenue pool o USD3.86

billion or the Islamic asset management industry. Fund sizes

however remain small, with more than 50% having assets

under management o USD20 million or less.

7 Ernst & Young, 2009a8 Ernst & Young, 2009b

Sukuk issuance shows improvement from 2008 setbackUSD billion

30

25

20

15

10

2001

Source: Dealogic

02

5

0

03 04 05 06 07 08 2009Year -

to - date

Table 5


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g. Development o comprehensive Islamic fnancial

inrastructure. Several key institutions have been established

to provide the inrastructure or the continuous growth o Islamic

nance. Among the key institutions are the IFSB, AAOIFI and

specialised institutions that provide Islamic nancial servicessuch as rating agencies, deposit insurance corporations and

mortgage corporations. IFSB, an international prudential

standard setting body was established in 2002 to develop and

disseminate prudential standards or regulation and supervision

o the Islamic nancial services industry. AAOIFI, an accounting

and auditing organisation, is responsible to develop accounting

and auditing standards or the Islamic nancial institutions.

Several international rating agencies have developed ratings

methodologies that recognise and incorporate the uniqueeatures o Islamic nance. Specic scheme on Islamic

deposit insurance has also been developed, while mortgage

corporations have issued sukuk to acilitate the widening

o asset classes available to investors in the Islamic capital

markets. Complementing these initiatives are the eorts by the

central banks in issuing Islamic monetary instruments which is

integral to the unctioning o the Islamic money market and the

Islamic nancial system.


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9 Ernst & Young, 2009

II. Perormance o Islamic Banks

16. The resilience o the Islamic nancial institutions during the recent

crisis epitomises the intrinsic strengths in Islamic nance, which

purpose and objectives are guided by the Shariah principles.

A study on the perormance o the top 10 conventional banks with

the top 10 Islamic banks indicate the ollowing9:

a. The combined market capitalisation o top 10 conventional

banks suered a decline o 42.8% vs. 8.5% decline in market

capitalisation by Islamic banks or the period between

December 2006 and May 2009.

b. Aggregate net prots o conventional banks ell dramatically

rom USD116 billion in 2006 to a net loss o USD42 billion in

2008. In contrast, Islamic banks net prot increased 9% duringthe same period rom USD4.2 billion to USD4.6 billion while

our o the conventional banks experienced losses (none o the

Islamic banks suered losses in 2008).

c. Between 2006 and 2008, total assets o conventional banks

grew by 36% to USD17.4 trillion while assets o the Islamic

banks grew by 55% rom USD94 billion to USD147 billion. The

growth in total equity during this period was 24% and 36% or

conventional and Islamic banks, respectively.

d. Conventional banks leverage ratio (Assets/Equity) was

16.6 times in 2006 which increased urther to 18.2 times in

2008. This was nearly three times the leverage ratio o Islamic

banks, which was 5.8 times in 2006 and 6.6 times in 2008.

e. Five o the top 10 conventional banks received government

nancial assistance to the extent o USD163 billion in aggregate,

or 26% o the aected banks combined equity. In contrast, only

one Islamic nancial institution required government assistance

to restructure and trading o its shares was suspended. As at

end 2009, none o the Islamic banks needed any government

rescue scheme.


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Chart 5: Market capitalisation of top 10 conventional and Islamic banks

pre & post crisis

17. Chart 4 compares the changes in market capitalisation, net

prot/(loss), total assets and equity between conventional banksand Islamic banks pre and post crisis. The ollowing charts (chart

5-8) show the perormance o individual banks with respect to

market capitalisation, protability, assets and leverage.

100.0

(%)

50.0

(50.0)

(100.0)

(150.0)

0.0

Change in total

assets

Change in net

profit / (loss)

Change in market

capitalisation

Change in equity

Top 10 Conventional banks

Top 10 Islamic banks

Chart 4: Changes in market capitalisation, net proft, assets and

equity - pre and post crisis


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Chart 6: Net profit/(loss) of top 10 conventional and Islamic banks

pre & post crisis

Chart 7: Total assets of top 10 conventional and Islamic banks

pre & post crisis

Chart 8: Leverage ratios (Assets/Equity) of top 10 conventional and

Islamic banks pre & post crisis

Sources:

Companyannualreportsandwebsites;nancialdatabasewebsites(ThomsonReutersetc.)

TheBanker,November2008reportontop500Islamicnancialinstitutions Ernst&YoungAnalysis

Note:

AllnancialgureshavebeenconvertedtoUSDoncurrentexchangerates.

AllguresareforDecemberyear-end,exceptMitsubishiUFJFinancialwhichhasMarchyear-end.Its2006

numbersareactuallyfor12monthsendedMarch2007.Its2008numbersareasof30September2008,thelast

reportedgures.Netprotfor2008isforsixmonths.

The2008numbersforInvestmentDararefor9monthsupto30September2008.

Asof1April2009,theKuwaitStockExchangesuspendedtradinginInvestmentDarssharesuntilfurthernoticeas

aresultofthepostponementofthereleaseofitsfullyearnancialresultsfortheyearended31December2008.

Thelistoftop10Islamicbanksintermsof2006marketcapdoesnotincludesomelargeIranianbankswhichclaim

to be Shariah compliant but their market data is not easily available.


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18. It is important to note, however, that the above observations are

subject to some important caveats:

a. The size o the Islamic banks is a raction o that o the

conventional banks. The top 10 Islamic banks market

capitalisation was only 3.1% o the top 10 conventional banksmarket capitalisation in 2006. While this has improved to 4.8%

in 2008, it remains small. The size o Islamic bank assets as a

percentage o total bank assets was less than 1% in 2008.

b. In the case o Gul-based Islamic banks, their relatively large

exposure to the real estate sector has been a key reason or

their weaker perormance. As a result, they suered rom price

corrections in the Gul property market.

c. Islamic banks are currently in an evolutionary and transitory

phase where there is a concentration o their assets in a ew

products which have been careully structured to largely

replicate the risk and return characteristics o conventional

nancial products. To the extent that this is diluting the

distinctiveness o Islamic nance, it could also expose the

Islamic banks to the destabilising orces inherent in the

conventional nancial system.

III. The Perormance o Islamic Indices

19. The Islamic nancial services industry has developed a stringent

set o criteria or investment, specically to acilitate investments

in the various stock markets around the world. These criteria

represent part o the screening process to identiy companies

which business activities do not comply with a minimum Shariah

compliant standard, thereby rendering their stocks ineligible or

purchase by Shariah based investors. The criteria include tests

at the level o a companys primary business and at the level o

its nancial or capital structure. In the more recent decade, such

Shariah screens have been adopted by the major international

index providers to establish specialised Islamic market indices.


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20. During the recent stock market crash, Islamic indices had allen

together with the conventional stock indices across the world,

but to a lesser extent. This could be due to the exclusion o

conventional banking and insurance stocks rom Islamic indices,

including stocks that ailed to pass the screens owing to thenature o their business (e.g. dealing in interest). Other companies

that were designated as being non-Shariah compliant are those

involved in gambling and other certain entertainment.

Dow Jones Islamic Market World Developed Index versus MSCI World Index

Total Return in USD

Dow Jones Islamic Market World Developed Index MSCI World Index

0.4

0.5

0.6

0.7

0.8

0.9

1

1.1

1.2

1.3

12/3

1/20

06

2/28

/200

7

4/30

/200

7

6/30

/200

7

8/31

/200

7

10/3

1/20

07

12/3

1/20

07

2/29

/200

8

4/30

/200

8

6/30

/200

8

8/31

/200

8

10/3

1/20

08

12/3

1/20

08

PercentReturns(%)

Chart 9: Dow Jones Islamic Index vs. MSCI World Index

Source: Aka, 2009

21. As shown in Chart 9, during 2007-2008, the total returns on the

Dow Jones Islamic Market World Developed Index declined by24.7%, while the outturn or its counterpart/proxy, the Morgan

Stanley World Index declined by 34.7%10.

10 Aka, 2009


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Chart 10: S&P Global Sharah Index vs. S&P Global Index

Source: OBrien, 2009

22. A similar outcome is apparent in Chart 10, which compares the

perormance o the Standard & Poors Global Shariah Index

vis--vis its Global Conventional Index. In 2008, the S&P Global Index

lost 42.5%, while its Islamic counterpart ell by 36.8%. This trend

is mirrored in the perormance o the S&P 500, which lost 38.6%,compared with its Islamic counterpart which declined by 28.9%.

23. Going orward, it is envisaged that the strong growth in Islamic

nance will be sustained, given the potential or widening the

current range o Islamic nancial products and services on oer,

as well as increasing demand, particularly rom the high number o

untapped markets.


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C: Challenges and Strategies or Strengthening FinancialStability in the Islamic Financial System

24. The recent international nancial crisis has revealed that ragilities

exist in the worlds nancial system, including in the moreadvanced economies. These have brought to the oreront key

issues regarding nancial intermediation, nancial innovation and

the regulatory and surveillance ramework that needs to be put

in place to provide the necessary oversight over such activities.

Although the Islamic nancial services industry was relatively

less aected by the crisis, its underlying causes bear important

lessons or the Islamic nancial industry going orward. This is

even more important as Islamic nance operates within the global

nancial system that is characterised by increasingly large andvolatile cross-border capital fows amid an environment o deeper

international nancial integration.

25. To support the orderly development o Islamic nance or

sustained global nancial stability, it is vital to accelerate the

development o critical building blocks o the Islamic nancial

system to respond to the changing economic and nancial

landscape. This is important to ensure a more integrated Islamic

nancial services industry globally that is able to withstand shocks

and adverse market developments through putting in place

building blocks that will strengthen the resilience o the Islamic

nancial system and by the application o mutually acceptable

rules and standards.

26. Moving orward, three key areas o priority warrant greater policy

attention to urther strengthen and enhance the entire Islamic

nance ecosystem:a. Strengthening the inrastructural building blocks o the Islamic

nancial services industry to urther enhance the industrys

resilience;


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b. Accelerating the eective implementation o Shari'ah and

prudential standards and rules to acilitate the creation o a more

stable, ecient and internationally integrated Islamic nancial

services industry; and

c. Creating a common platorm or the regulators o the Islamicnancial services industry to enhance constructive dialogue.

I. Strengthening Islamic Financial Inrastructure

27. It is critical to build the robust components o the nancial

inrastructure as well as strengthen the key institutions, at both the

national and international level, to ensure the stability and dynamism

o Islamic nancial system. This report has identied eightbuilding blocks aimed at urther strengthening the Islamic nancial

inrastructure at the national and international levels to promote a

resilient and ecient Islamic nancial system.

Comprehensive set o cross-sectoral prudential standards

28. The frst building block in securing nancial stability is the

development o a set o comprehensive, cross sectoral prudential

standards and supervisory ramework covering Islamic banking,

takaul and capital market which takes into account the specicities

o the IIFS.

29. The IFSB has issued a whole spectrum o prudential and

supervisory standards which constitute the equivalent o Basel II

in Islamic nance covering risk management, capital adequacy,

corporate governance, transparency and market discipline. These

standards take into account international prudential standards

across the banking, investment and securities and insurancemarkets issued by the Basel Committee on Banking Supervision

(BCBS), the International Organization or Securities Commission

(IOSCO) and International Association o Insurance Supervisors

(IAIS), respectively, and simultaneously cater eectively or the

specicities o Islamic nancial rms, their risks and Shariah

compliance. Appendix I provides a ull list o the standards and

publications issued by the IFSB.


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30. Signicant eorts to issue comprehensive prudential standards or

the Islamic banking sector have contributed towards establishing

an internationally consistent ramework or Islamic banking that

is equally robust as those applicable to the conventional banking

sector. This includes a sound capital adequacy rameworkequivalent o Basel II or Islamic banking. Appendix II provides

comparison between IFSB and BCBS standards.

31. However, greater attention is needed to expedite work on a more

comprehensive set o prudential standards or the takaul sector.

IFSB spearheads this eort through a number o key initiatives.

In August 2006, IFSB and IAIS issued an Issues paper on the

applicability o the existing insurance core principles11 (ICPs) to the

regulatory and supervisory standards or takaul to be developed

by the IFSB. Some o the ICPs are universally applicable and

require no adaptation to apply to takaul. However, some o the

ICPs appear to require some adaptation, or example, in the areas

o corporate governance, nancial regulation and market conduct.

In December 2009, IFSB issued a standard on the governance o

takaul. A standard on the solvency o takaul is at an advanced

stage o preparation. Appendix III shows the comparison o

standards between IAIS and IFSB.

32. It is also important to ensure closer cooperation among

policymakers and nancial supervisors with dierent mandates

and in dierent jurisdictions in order to enhance the resilience and

stability o the IFSI. In this regard, the IFSB has emphasised the

need or the adoption o a coordinated cross-sectoral approach

to the regulation and supervision o IIFS that encompasses the

banking, the investment and securities market and the takaul

sectors. To address contagion risks, the regulation o non-nancialactivities o nancial conglomerates would also need to be

appropriately structured.

11 The IAIS insurance core principles (ICPs) provide globally accepted principles or the regulation and supervision oinsurance sector.


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Development o a liquidity management inrastructure

33. Thesecond building blockin enhancing nancial resilience and

stability o the IFSI is the development o a robust national and

international liquidity inrastructure, which encompasses the

potential or monetary policy and money market operations. Thisis important not only to reduce the cost o intermediation, but

also to infuence the level o liquidity in the nancial system and

achieve eective management o monetary policy. Robust liquidity

management inrastructure is also vital in preserving nancial

stability or central banks to perorm the lender o last resort

(LOLR) unction and to provide liquidity to the market. The ability

o IIFS to weather a liquidity crunch is contingent upon the access

to a robust liquidity management inrastructure, which is currently

still underdeveloped in most o the jurisdictions in which Islamicnancial services are oered. The tools or liquidity risk management

presently available or use by IIFS remain rudimentary and markets

are insuciently liquid, leading to ineciencies in normal times (due

to low returns on liquid assets) as well as the potential or systemic

risks in times o crisis owing to the relative limited liquidity o the

instruments involved.

34. Towards addressing this, the IFSB has established a High LevelTaskorce on Liquidity Management (HLTF), mandated to develop

a liquidity ramework to acilitate and oer liquidity solutions to

market players so as to promote better liquidity management by the

Islamic nancial institutions. The HLTF is also mandated to study

the viability o the proposal to establish an entity which would issue

Shari'ah compliant instruments that are highly liquid and transerable

in the secondary nancial market.

Strengthening fnancial saety nets

35. The third building blockrelates to the strengthening o the nancial

saety net mechanism, namely, LOLR acilities and emergency

nancing mechanisms as well as deposit insurance, all o which

need to be compatible with Shariah principles. While the current


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practice o managing liquidity through interbank Murabahah or

Wakalah arrangements, structured nance and enhanced deposit

schemes may unction well under normal market conditions, more

ecient and tradable Shari'ah compliant nancial instruments are

required or LOLR acilities and emergency nancing operationswhen inter-bank liquidity comes under pressure in a crisis situation.

This calls or the development o an adequate range o tools and

instruments or LOLR and emergency nancing operations that are

consistent with the core objectives and principles o Shari'ah both in

orm and in economic substance.

36. Deposit insurance, together with prudential supervision and the

LOLR unction, represent the other key components o the nancial

saety-net arrangements or sustaining nancial stability, especially

when conronted with a nancial shock. The implementation o

a well-designed Shari'ah compliant deposit insurance scheme

or Islamic nancial services is particularly challenging given the

intricacies o the unding structure o IIFS. The on balance sheet

unding structure o IIFS in almost all countries is composed mainly

o current accounts and unrestricted prot sharing and loss bearing

investment accounts (UPSIA), and in most IIFS, these investment

accounts constitute the major source o unding. While explicit

depositor protection may be provided or current accounts under

a Shari'ah compliant (takaul based) deposit insurance scheme,

an issue arises when insurance coverage is provided or UPSIA.

Contractually, UPSIA should bear their own commercial risks, as

in the case o investors in a collective investment scheme (CIS).

While Shari'ah requirements in this respect would be met by the

UPSIA themselves being the participants in the scheme, providing

insurance coverage or UPSIA might raise several concerns relating

to matters such as: the appropriate air value o UPSIA that should

be insured; the evaluation o the riskiness o the underlying assets;

the quality o the asset management or the purpose o setting

the levels o the takaul contributions and the unlevel playing eld

between UPSIA as investors in IIFS vis--vis investors in a CIS.


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refect the risk characteristics o IIFS. In parallel, urther progress

is needed in updating the accounting and auditing standards or

IIFS to that o the international standards, in order to complement

the developments in prudential and risk management standards.

Above all, there needs to be a monitoring and assessmentmechanism to encourage countries to implement the standards.

Macro-prudential surveillance

40. Thesixth building blockreers to the development o the macro-

prudential surveillance ramework and nancial stability analysis,

which is an integral part o the strategy to strengthen the resilience

o the Islamic nancial system and to minimise the risks o nancial

ragility. The traditional micro prudential supervision approach

cannot eectively address system-wide stress that might develop

due to common exposures o nancial institutions. In this respect,

there is a need to have a macro prudential surveillance ramework

that complements the traditional micro prudential supervision o

individual institutions.

41. One o the challenges in the implementation o this macro prudential

ramework relates to the development o indicators that would not

only provide a basis or the assessment o nancial soundnessand risk to vulnerabilities o the nancial system as a whole and

its components, but also acilitates an analysis and assessment o

how these indicators might interact with broader macroeconomic

developments. Such an assessment o systemic implications would

enhance the ability to anticipate the potential threats to nancial

stability. In this regard, the IFSB has embarked on an initiative to

establish a global database o prudential Islamic nance statistics.

This would contribute towards standardising the measurement

methods and reporting structures o key nancial soundnessindicators or Islamic nance, thereby promoting international data

comparability. As timely and accurate inormation and statistics is

key enabler to this process, it is thereore necessary to ensure that

similar advancement in inormation technology is made to cater or

the unique characteristics and eatures o Islamic nance.


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Strengthening rating processes

42. Theseventh building blockis to review the rating process or

Islamic institutions or instruments by re-examining and improving

the related core processes to encourage greater transparency on

the risks involved. A robust rating process is an integral part o

the building blocks to address the apparent ailure o the rating

agencies to assign accurate ratings on new, complex securities,

beore the onset o any crisis12.

43. Rating agencies need to ully appreciate the unique eatures,

characteristics and risk proles o Islamic institutions and

instruments. It is important to adopt a more holistic rating

process, encompassing the duciary aspects and credit riskwhile giving due consideration to the transparency and visibility

o the underlying transactions and the quality o the management.

44. The rating and methodology process also need to be

re-examined to encourage greater transparency. As Islamic

nancial institutions are involved in duciary relationship, the

rating process should emphasise on the management o risk

sharing in certain products and services (such as PSIA), and must

be recognised in the credit rating assessment.

Capacity building and talent development

45. Finally, as the eighth building block, international Islamic

supranationals and developmental bodies need to consider

more involvement in capacity building to promote global

nancial stability. Islamic nance is an industry that is dynamic

and complex with rapid product innovation. To excel and

produce results in a more challenging globalised environment,practitioners and stakeholders in the Islamic nancial services

industry need to be highly qualiied and equipped with the

12 For instance, during the onset o the crisis, rating agencies competed with each other to rate MBS and CDOsecurities issue by investment banks as the remuneration and incentives are three times more than grading lesscomplex, traditional corporate bonds.


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requisite technical knowledge and skills. O importance is the need

or more collaborative eorts by various research and training

institutions in dierent jurisdictions to design and oer capacity

building modules in key areas across multiple jurisdictions.

Collaboration in this area would also enhance capacity buildingamong countries and Islamic nancial services industry players to

develop the best practices and standards, harmonise o Shari'ah

practices, review standards to acilitate policy development and

implement o standards and policy ramework.

46. Eorts to enlarge the human capital pool are imperative to keep

pace with the rapid growth o Islamic nance. Investments in

human capital development through specialised training and

educational institutions are important to support the global

development o Islamic nancial services industry. Talent

development and educational institutions specializing in Islamic

nance that have been established in several jurisdictions should

be encouraged to orge strategic alliances across borders.

II. Accelerating Eective Implementation

47. Going orward, steps need to be taken to implement the eight

building blocks. Eective implementation is important to ensureenhanced resilience o the industry and greater linkages among

Islamic nancial institutions and markets. There are three

dimensions to this process:

a. Implementation o the prudential standards;

b. Mutual understanding o Shari'ah views globally on key issues

in Islamic nance; and

c. Emphasis to encourage an inclusive system.


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Implementation o the prudential standards

48. Theimplementation o the prudential standards that have

been issued by the IFSB is important. This is critical in the

harmonisation o prudential standards, in promoting and enhancing

the soundness and stability o Islamic nancial services industry,

as well as in contributing towards the consistent development o

Islamic nance across dierent jurisdictions. Several jurisdictions

have implemented the prudential standards issued by the IFSB,

which have been designed based on the unique eatures o Islamic

nance and will contribute towards ensuring its soundness and

stability. This should be supported by a transparent and credible

assessment process which would serve to assist jurisdictions in

evaluating their level o compliance with international standards and

make recommendations or improvements such as peer reviews or

the Financial Sector Assessment Program (FSAP) process.

Mutual understanding o Shari'ah views on key issues across

jurisdictions

49. This is essential as varying interpretations o Shari'ah in key

issues in dierent countries or markets add to the complexity

when cross-border transactions are involved. Mutual recognition

o nancial standards and products across jurisdictions wouldacilitate the integration o Islamic nance across the world and in

bridging the global markets. This convergence and harmonisation

is taking place with the greater engagement among the regulators,

practitioners and scholars in Islamic nance across jurisdictions.

The industry also needs to develop innovative and diversied

Islamic nancial instruments which can be readily accepted by the

Islamic nancial institutions in various jurisdictions.

50. Key to this is to ensure that a consistent interpretation across

jurisdictions is applied to the issues acing the industry. It is important

or the industry to have a general understanding o the undamentals

o Islamic nance and in embracing the uniqueness o Islamic nancial

structures and their risk proles. The industry needs to recognise

the theoretical merits o Islamic nance as espoused by Shari'ah

objectives and principles. When embraced in its entirety, these


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essential eatures reduce the risks o nancial instability. While

innovation is to be encouraged, it must be consistent with the

essential eatures o Islamic nance that are in compliance with

the principles o Shari'ah and aligned to the objectives o Shari'ah.

This is an important transormation o Islamic nance rom thedominant strategies pursued in previous decade o emulating the

products and services o its conventional counterpart. This would

separate Islamic nance rom the same misalignments between

assets and liabilities prevailing in the conventional system, and

thus reduce the risks o nancial panics. In attaining a sucient

degree o dierentiation, Islamic nance can become a valuable

partner within the global nancial system.

Emphasis or Islamic fnance to be a more inclusive system

51. Islamic nance also emphasises the development o a more

inclusive system, within a broader Islamic nancial ecosystem.

The hardships o the vulnerable segments o the society are oten

compounded during economic and nancial crises. In the Islamic

nancial ecosystem, the institutions ozakat andawqafcontribute

towards alleviating such hardships. In addition, greater access

to nancial services enables broader participation in the nations

development process. Islamic nance, in achieving the objectiveso Shari'ah (Maqasidal-Shari'ah), makes nancial services relevant

or a larger segment o the world population. Micronance is an

important part o this initiative.

52. Eective strategies or the development o micronance have been

developed by the cooperatives, non-governmental organisations,

the Islamic banking institutions throughzakat/awqafunds and

multilateral institutions including Islamic Development Bank

(IDB). With enhanced and strengthened resources, multilateralinstitutions such as the IDB can have a larger role in improving

services to the Islamic micronance sector.13

13 A recent IRTI document on Strategies and Framework or Development o Islamic Micronance Servicessuggests a number o specic initiatives that would go a long way in strengthening nancial inclusion andenhancing accesses o the poor to nancial services.


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III. The Establishment of a Platform for Constructive Dialogue:

Islamic Financial Stability Forum (IFSF)

53. Key to achieving fnancial stability is to have a strategic platorm

or conducive and constructive dialogue among the regulators

o the international Islamic fnancial system. As Islamic fnance

continues to become an integral part o the global fnancial system,

there is scope or the current ramework o cooperation to be

strengthened and broadened to address the new challenges that

have emerged.

54. In this regard, the Task Force recommends the establishment

of an Islamic Financial Stability Forum or IFSF based at the

IFSB, which shall, inter alia, be a broad-based and constructivestrategic platorm or IFSB members to achieve the primary

objective o building cross-border dialogue in eorts to promote

fnancial stability within the Islamic fnancial system. The

objective o the IFSF will be to acilitate better understanding

o emerging developments in the Islamic fnancial system and

their implications or national and global fnancial stability. The

IFSF also would have the potential to promote collaboration and

cooperation in remedial policies to prevent, contain and manage

emerging issues in Islamic fnance.

55. It is envisaged that the IFSF will provide a strategic platorm

or IFSB to enhance collaboration in Islamic fnance to promote

stability in the IFSI and the global fnancial stability. The IFSF will

be a dedicated orum to promote cooperation and collaboration

among its members in areas such as surveillance, sharing o

experiences in crisis prevention, management and resolution,

implementation o international standards as well as international

cooperation in capacity building and in the development o

emergency inrastructure and acilities.


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56. It is envisaged that the IFSF can serve as the orum to deliberate

on the ollowing agendas:

a. Establish an integrated mechanism or macro-monitoring o the

developments in the global Islamic nancial services industry;

b. Assess vulnerabilities and emerging risks to Islamic nancial

systems and the implications or global nancial stability

including cross nancial systems assessments;

c. Propose and advise on policy actions and responses to deal

with the identied risks and vulnerabilities;

d. Establish an integrated crisis management and resolution

ramework and arrangements and ensure the continued

eective and ecient unctioning o the ramework and

arrangements;e. Develop a communication mechanism to collaborate and

exchange inormation and experiences with the IIFS, regional

ora and regulators/supervisors on nancial stability issues;

. Promote cooperation and coordination among relevant

authorities and Islamic nancial institutions on nancial stability

by acilitating reviews and implementation o international

standards; and

g. Focus attention on issues o coherence and convergence, and

on opportunities to increase the eciency, integrity and stability

o Islamic nancial markets.

57. As Islamic nance will continue to be an integral part o the global

nancial system, it is important to have an integrated initiative, both

or conventional and Islamic nance, to preserve nancial stability

at the global level. Key to this is to maintain an interace between

the Financial Stability Board and IFSF so as to ensure there would

be constructive exchange rom the perspectives o conventionaland Islamic nance to maintain global nancial stability.


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Conclusion

58. Islamic nance continuous expansion to become an integral part

o the international nancial system, presents unique opportunitiesand challenges. Islamic nance needs to urther strengthen its

resilience to withstand all possible market imperections and

uture shocks. It has to draw on its intrinsic strengths to solidiy its

posi

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